8/28/2009 @ 6:00PM

Peek Ahead With The Put-Call Ratio

If you know when fear or greed reach unsustainable extremes in the market, you give yourself a better chance of identifying possible turning points. Options trading activity can yield very valuable clues in this regard, and one of the most reliable indicators I’ve found is the put-call ratio, a useful, sentiment-based, technical indicator.

It’s a contrarian indicator, so the higher the put-call ratio, the more pervasive the bearishness and thus the greater the likelihood that the market will turn higher and prove the crowd wrong, as it has a long track record of doing. On the flip side, a low put-call ratio suggests an overabundance of bullishness and provides an early warning of a possible downturn.

If you plan to use the put-call ratio as an indicator for your own trading–as I have in my newsletter and money management business–you need to be aware of two different types of put-call ratios: standard and weighted.

The standard put-call ratio is simply the volume of all put options that traded on a given day divided by the volume of call options that traded on that day. The ratio can be calculated for an individual stock, index, or futures underlying contract, or can be aggregated. For example, I often refer to the equity-only put-call ratio, which is the sum of all equity put options that traded divided by all equity call options on any given day. Once the ratios are calculated, a moving average is generally used to smooth them out. We prefer the 21-day moving average for that purpose, although it is certainly acceptable to use moving averages of other lengths.

A dollar-weighted put-call ratio is constructed by using not only the volume of the various options, but their prices as well. The two (option closing price and total option daily volume) are multiplied together, and the total of that product for all put options is divided by the total of that product for all call options. That computation is the daily weightedput-call ratio. As with the standard put-call ratio, this weightedratio can be computed for individual stocks, futures or indexes, or for aggregated groups of options. What this weighted ratio attempts to show, which the standard ratio does not, is how much money is being spent on puts vs. how much money is being spent on calls.

The thinking is that it is more important to know how much total money is being spent on puts vs. calls, than merely to know the volume. This point has some validity. For example, a person who is merely hedging his position perhaps is not really all that bearish, but just wants to buy some puts as insurance. He might buy fairly deep out-of-the-money puts. Thus, his dollars would be spent on rather low-priced puts. On the other hand, a truly bearish speculator would most likely buy a put that is at-the-money, or perhaps slightly in-the-money. Thus, this true bearishness would perhaps result in a higher expenditure in terms of dollars.

The main difference between the normal and weighted ratios is that the weighted put-call ratio generates more extreme readings–especially at major turning points. That is, during bullish periods the weighted reading can dip down to 0.20 or below on a given day, even pushing the 21-day moving average down to those minimal levels at times. The standard put-call ratio rarely gets that low, especially where equity options are concerned. During extreme bearishness, the weightedratio will easily rise above 2 on some days, and the 21-day average can rise to nearly 2 as well. Again, those kinds of numbers are generally unheard of for the standard ratio.

Boeing

The chart above shows the weightedput-call ratio for Boeing overlaid on an unscaled stock price chart, going back about one year. Buy and sell points are marked on the chart. Note that buy signals occur when the ratio is toohigh (at local maxima on the chart) and sell signals occur when the ratio is too low (at local minima).

You can see that, in general, the signals are good ones. In reality, we couple technical analysis B using support and resistance levels B with the signals generated by the put-call ratios. The combining of the two methods normally produces better-timed entry and exit points in our trades.

Standard Put-Call Ratio

Weighted Put-Call Ratio

As another example, let’s look at the big picture, via the equity-only charts. The two charts above show the standard ratio (on top) compared with the weighted ratio (on the bottom). The buy and sell signals are marked on the charts. For these charts, the major buy and sell signals occur at relatively the same points in time.

Of all the technical indicators I have seen in my nearly 40 years of trading, the equity-only put-call ratio is far superior to most–if not all–others.